19.5 Earnings per Share Analysis

Basic EPS is an indicator that uses historic financial data, such as net income, and an average based on actual shares outstanding from the reporting period just ended. Over time, EPS trends can help shareholders and potential investors to determine if performance is on an upward or a downward swing. These trends can assist in forecasting future performance based on what happened historically.

Diluted EPS is an indicator that is forward-looking. It quantifies the impact that exercising options, and potentially convertible securities, will have on current earnings available to common shareholders.

Price-earnings ratio (P/E) is an important measure of company’s performance. It measures how investors evaluate a company’s future performance and is calculated as:

If the market price for ABC Ltd. as at December 31, 2018, and 2019, was $43.29 and $45.86, respectively. Using the EPS of $2.98 from the company’s financial statements, the price-earnings ratios, using the market prices as high and low figures, are calculated as follows:

Low:

High:

The P/E ratio indicates the dollar amount an investor can expect to invest in a company to receive one dollar of that company’s earnings. Therefore, the P/E is sometimes referred to as the multiple, because it shows how much investors are willing to pay per dollar of earnings. Using the figures from the calculations above, if a company was currently trading at a multiple (P/E) of between 14.5 and 15.4, the interpretation is that an investor would be willing to pay between $14 and $15 for $1 of current earnings.

In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. It could also mean that the company is currently overvalued by the market, which may lead to a market correction of the stock price in the future. Conversely, a low P/E ratio can indicate that a company may currently be undervalued.

Like any other ratios or analytical tools, basic and diluted EPS and the price-earnings ratio are not meaningful unless compared with something else, such as a company’s historical trend. Also, EPS based on income from continuing operations is a more relevant performance indicator and forecasting tool than EPS on net income, which may include discontinued operations.

EPS as a single measure obscures important information about the company’s selection of accounting policies, estimates, and valuations. As illustrated in the diluted EPS calculation above, the calculations for EPS are complex and can be manipulated like any other analytical tool. For this reason, EPS should be only one assessment tool of many that would comprise an informed analysis of a company’s performance and overall health.